The Fed's Not So Excellent Adventure

Quantitive easing, qualitative easing, yield curves, repos, interbank loans, interest rates, reserves, sterilization, discount windows, open market purchases, monetization, and of course mesmerization to calm the speculators are just some of the monetary gears and wheels that to the untrained eye appears to be a Rube Goldberg machine that no mere mortal can comprehend. To others it is not a machine, but a dance where bond and stock markets undulate to the monetary music emanating from the central bankers. It is simply impossible to stand still on the intoxicating monetary dance floor with yesterday's interest rate too low, and tomorrow's too high. But the needle on the old vinyl LP seems to be stuck in a rut. Central bankers around the world have painfully discovered that their textbook theories of money supply and low interest rates fall short (e.g. near zero interest rates did not bring hyper inflation, nor the missing borrowers to the table). So what once sounded like a beautiful melody is grinding louder and louder as noise.

In an attempt to separate signal from noise, I thought it might be fun to take my theory of economics which fully rejects the Quantity of Money (QTM) and apply it to the logic of central banking and see where the chips might fall. As the readers of my previous articles (listed below) know, I have argued there has never been a sound theory of economics because there has never been a complete theory of money. In short, I define money as "domestic arbitrary scale" which can only function properly in a closed (protectionist) economy. Under this new definition, fiat (paper) money is treated as effectively infinite in supply, and relies on the critical mechanism of a minimum wage defined by government decree.

To make the case that the central bankers will not be able to pull their nations away from the economic abyss of free trade, let me start with a very simple model of how an industrial economy works. It is a model that ultimately helped me grasp the 200 year old error of all schools of economics. It also brushes aside the endless confusion regarding the relevance of interest rates, savings, and taxation. I also hope it might help the layman to begin to understand how money really works.

Let's begin building our model by replacing all banks with a computer that hands out industrial loans only (speculative real estate is a story for another day). The computer is maintenance free and is so smartly programmed that the loan risk is zero, and thus it charges no interest. Now imagine the economy consists of two factories, one which makes bread, and the other makes cheese. Each factory has 100 workers. Each week, the factory owners go to the computer to get a loan to pay the weekly wages and buy materials. Each week they make a $5000 worth of bread and cheese respectively. Each week the workers fully consume each other's output ($5K of cheese and $5K of bread). As a result, each week the loans are fully paid off. Debt is temporarily created, and then extinguished with repayment every week.

We make a few critical observations at this point. The loan was created out of nothing. It is really just a set of bookkeeping entries to keep the economy humming and honest. More importantly, there is no limit on the amounts of credit the computer can create, yet there will be no inflation. Thus the money supply is effectively infinite. Let's dig into this point further. Mainstream economics teach that an infinite money supply should create hyper inflation. Said differently in economics jargon: 1) the Quantity of Money (QTM) determines the general price level, 2) Money is a veil, 3) Infinitely and instantly flexible prices/wages of general equilibrium models adjust to the quantity of money, or 3) Pricing is the result of supply and demand (i.e. barter). All of micro, macro, and free trade economics is built on this erroneous belief of money supply and price levels/wages. An exception to such a generalization could be argued by the Post Keynesians, but since they seem to be forever lost in the idea of capitalism's inherent instability, I feel the Post Keynesians have missed the fact the money in a closed economy acts as the stabilizing force. Regardless of such finer distinctions among schools of economics, I fully reject the modern principle of money as an "afterthought" in economic modeling. Instead, for a fiat/paper money model economy (i.e. our computer), I suggest that we have to take the missing step and require that a minimum wage be defined by government decree. As far as I've been able to determine after six years of research and 200 plus economics books, no one has made such a specific claims (gladly stand corrected). Keep in mind as we proceed, that modern economics considers a minimum wage as an obstruction to all their economic models. The reasoning is that "modern" barter based models require full price flexibility. A minimum wage break such models, and therewith free trade models.

Before we return to our computer/factory loan model, let's expand on this idea of a minimum wage, because it is the critical intellectual step we need to make to save our nation from economic ruin (i.e. de-industrialation). Begin by imagining a war torn country whose currency was destroyed by hyper inflation and is being replaced by a new currency of a different unit. Next, imagine the government informs all its citizens that it will issue each citizen 1000 Ziggles in a lump sum to help get them started. Notice the "value confusion" that has resulted. Having no reference point, some might spend the money in a week, while others might spend it over 1 year. As a result, no one has any idea what worthless and infinite-in-supply paper money is worth. Now imagine a slightly different scenario, where instead the government says it will issue 100 Ziggles per week for 10 weeks of basic labor. Suddenly, the average worker can grasp what 1 Ziggle is worth. To hammer this point home, it is not hard to imagine that the average man on the street can come pretty close to guessing what the minimum wage is, verses guessing what the nation's money supply is. This scenario is essentially the effect of a minimum wage by decree. The factories can immediately begin hiring workers at this wage, and asking for loans against this wage level. Thus the money supply is irrelevant, as long is it is not cut off.

There are additional observations to make from this simple model. Interest rates are irrelevant, because supply is infinite. It serves no real function in this model. The factories will happily run without interest charges. If you feel this is avoiding the issue, then I simply ask the following question: Is China's road to riches due to a magic interest rate popping out of a supercomputer? Of course not. It is due to building the biggest and strongest industrial base in the world. If this suggestion is too simplistic, then simply consider the following scenario. If interest rates are 10% instead of 5% percent we drive smaller cars and have smaller homes to cover the high default risks (or for the skeptic, high bank profits). Regardless of the rates, the economy will hum along if the foundation is sound (closed). It might mean a lower standard of living for the average man on the street with a higher interest rate, but then again it might not. Imagine a nation with a high percentage of risk takers and thus a high default rate. Yet if a few of these risk takers succeed at high productivity gains, they may actually reduce the construction cost of your next car and therefore raise your standard of living, in spite of higher rates. In either case, rates are not the ruin of a nation.

Also notice in this model the workers do not save a portion of their weekly income. If they did save, it would amount to unemployment or increasing inventories. Fortunately this is not too far from reality, because national saving rates are typically stable year to year, because while some save, others "unsave." The net change is zero. Therefore, saving is not the road to prosperity as some of the gold bugs and libertarians might have us believe. Goldsmiths a few hundred years ago over issued deposits slips essentially pioneered our computer model. In fact, issuing unlimited industrial credit against a single gold coin is superior than digging out gold from the mines. To grasp this, notice in our computer model the exchange involves two goods with the associated debts extinguished following the exchange. Compare this against the gold-bug/libertarian scenario. Imagine one factory and one gold mine with 100 workers each. One produces bread and the other the equivalent of gold to buy the bread. Labor content of each is the same. Now notice the problem. There is only enough bread for 100 workers. This will be inflationary, since the each ounce of gold dug out of the ground can not be "extinguished." Gold is not a superior form of money as result (even the Spanish understood this problem when gold-laden Conquistadors returned to Spain). Note also that gold is not some mystical universal measure between nations as the classical school of economics erroneously believed. In each country the labor content in an ounce of gold is potentially radically different, implying gold is nothing more than a "domestic arbitrary scale". In other words, gold is not different than fiat money in terms of how it sets the domestic scale; thus gold is subtle form of minimum wage. James Steuart, writing before Adam Smith, pioneered this idea of an arbitrary scale, but could not close the logic on the domestic aspect.

Along this line of logic we can expose the flaw of Chartalism and Modern Monetary Theory (neochartalism) which argues government taxation ultimately gives money it value. As we saw above in the computer model, no taxes need to be collected for this model to work. In a historical gold setting, no government decree would have been required either, because the labor content of gold is the naturally derived baseline. In summary, in my world view, taxation is not a necessary component of monetary theory. The capitalist and banker would have functioned just fine without paying taxes. Taxation in our computer model would simply mean a tap into the wage stream of the worker amounting to a forced exchange of worker output for government worker output. It does not fundamentally change our model, it only means the factory worker is no longer free to spend his full income on industrial goods.

In the world of conventional thinkers, the computer is what matters, not the industrial base if our lack of industrial policy is any indication. Mainstream thought amounts to the paranoia of unplugging the computer. Granted, unplug the computer and the economy comes to a halt, but it is not the foundation of an economy. And there probably is a case to be made for the removal of bad assets from the bank books because it can amount to unplugging the computer. But this is a debate for a different day. Our position here is that the belief in the power of monetary manipulation as a general pancea is a distraction for a much greater problem: Industrial flight overseas. Industrial wealth production is the root of prosperity. Industrial production's productivity gains (industrial, chemical, electronic) spawn all other sectors (else we be subsistence farmers). The industrial base can only function correctly in a closed economy, because only then can domestic money function properly (see link below for work mobility and industrial logic details).

The danger in placing our focus and faith in central banking is that it fails to understand that free trade will remove the private borrowers (industrial base) from the market place which ultimately sustain the banking and finance industry. Just as an accountant is necessary to running a factory, it is the outputs of factories which puts food on the accountant's table. Lincoln understood the absolute necessity of industrial credit, but he also understood it relied on closing the economy to protect the industrial base. We seem to have forgotten this insight, perhaps because economists have traditionally been free traders. As a result, the globalization stage has become the theater of the bizarre. American financial markets recoil at the mere discussion of a possible fractional percentage change in interest rates, while the Chinese laugh all the way to the bank with their industrial earnings regardless of the interest rates. Could it be the Chinese might have something to teach us about economic theory, the same theory of protectionism our founding fathers and Lincoln understood?

Link to links:

Van Geldstone